Question

1. Why do larger banks tend to have lower net interest margins?

2. What are some examples of economies of scale for banks? And Diseconomies of scale?

3. What are some examples of economies of scope for banks?

Answer 1

Why do larger banks tend to have lower net interest margins?

The extraordinarily low interest rate environment that has prevailed in the wake of the financial crisis has put downward pressure on the NIMs of all banks, but especially the largest ones. Over roughly the past five years, NIMs of large banks have fallen 70 basis points, while NIMs of small banks have decreased approximately 20 basis points. The more pronounced decline in NIMs at large banks is driven by two main factors related to the low interest rate environment.

• The first factor arises from the liability side of banks' balance sheets, namely from a more pronounced decline in funding costs at small banks, and accounts for the majority of the difference in the behavior of NIMs between large and small banks.
• The second factor stems from the asset side of the balance sheet. Specifically, in recent years large banks have experienced a somewhat bigger decline in the interest income that they earn on "other" assets, which includes assets held for trading purposes.
• During previous monetary policy tightening episodes, the rates banks pay on deposits have risen more slowly than market rates, allowing banks to increase their NIMs.
• In particular, during the next monetary policy tightening episode, large banks could try to boost their profitability in the short term even further by delaying an increase in their deposit rates relative to previous tightening cycles. If that happens, more deposits than usual could leave the banking system, putting some downward pressure on the level of short-term interest rates.
• However, with interest on excess reserves higher than many deposit rates, and with the currently high level of excess reserves helping banks meet their liquidity requirements, banks may instead act to preserve deposits as a funding source, accelerating the pass-through to market interest rates relative to previous tightening cycles. That said, this latter effect may be damped because many large banks face balance sheet constraints in light of the new regulatory environment.
• In particular, the Basel III leverage ratio, which requires the same amount of capital be held irrespective of the risk of the underlying asset, may reduce the incentives for banks to preserve this funding source.